Sunday, November 15, 2009

Ignorant Reporting

The New York Times fails basic economics.  They ran an article talking about cell phone prices and saying that nobody understand them.  But the market structure of cell phone pricing is actually quite easy to understand.

I guess it isn't all their fault.  They interviewed an 'economist' at Yale who obviously forgot or never learned basic price theory.  If they had asked anyone in our econ department, they would have gotten a good explanation of the pricing system:

There are different people, with different demands for mobile phone minutes.  Some people want to talk a lot, and others only want to talk a little.  If a phone company offers a flat rate price to everyone, they will have to charge a price that is too high for the people with low demand, while being too generous to the ones with high demand.

The way to solve this is with two-tier pricing.  You set up two or more different plans.  For each plan, you charge an 'entrance fee' that has a certain bundle of minutes, and then charge a per-minute fee if those free minutes are used up.  The people who talk the least choose the plan with the lowest entrance fee.  They will never use up their minutes, so they don't care how high the per-minute prices are.  That high cost is only there to keep the chatterboxes out of the cheap plans and force them into the expensive plans.

The math gets complicated, but you can prove that this method gives you more revenue than a simpler price system.  It also lets you serve more people, because you have figured out how to get money from the people who don't use phones much, without giving anything away to the talkers.  The article mentions, in passing, that Americans pay the least amount of money on average for their phone calls.  This is because of our system of 'complicated' plans, which allows the companies to get more users into the system and make the best use of the network.

There are several other points where the article fails basic econ or finance:

The article claims that the new iPhone price of $199 now and signing a contract to pay $30 a month for two years costs more than the old plan of $399 now and $20 a month.  But this calculation ignores the interest rate.  Money spent two years from now is cheaper than money spent today.  I did a quick calculation and found that, at an interest rate of 18% a year, the net present value of the two plans is almost identical.  This may seem like a high rate, but it is lower than what credit card companies charge.  If you put that $399 on your credit card, then the old plan would cost you much more money than the new plan.  So it was perfectly rational for consumers to be willing to buy more phones at the new plan.*

The author thinks it is odd that offering a discount makes people switch to more expensive plans.  But that isn't odd.  The basic reaction to a price cut is to buy more of the thing.  When a company does something to lower your bill, you have more money to spend, so you choose to upgrade the plan and talk more.

*From an economics standpoint, there is nothing irrational about using credit cards and paying high interest rates.  It just means that you value consumption today a lot more than you value consumption tomorrow.  You have a high 'discount rate'.  When economist say people are rational, they are saying that people will find the most efficient way to get what they want.  We never assume that what they want is 'rational' in the sense of being what a wise or intelligent person would choose to do.  A 'rational economic agent' might have a cocaine habit.  But he or she will try to get that cocaine for the best possible price.

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